Structural rules of the Internet age laid out almost 80 years ago

By John Naughton / The Observer, LONDON

When the news broke last week that Ronald Coase, the economist and Nobel laureate, had died at the age of 102, what came immediately to mind was John Maynard Keynes’ observation that “practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

Most of the people running the great Internet companies of today have probably never heard of Coase, but, in a way, they are all his slaves, because way back in 1932 he cracked the problem of explaining how firms are structured, and how and why they change as circumstances change. Coase might have been ancient, but he was certainly not defunct.

As an economics student at the London School of Economics in the 1930s, Coase was puzzled by the fact that economic theory ignored the workings of the firms that make up the economy. Economists were obsessed with the big picture — the way prices act as Adam Smith’s “invisible hand,” bringing supply and demand into equilibrium. However, like Edwardian aristocrats disdaining “trade,” they seemed blandly uninterested in the ways in which businessmen actually made decisions.

“What is studied,” Coase said, “is a system that lives in the minds of economists, but not on Earth.”

So he got a scholarship and went to the US to examine how companies actually worked. The thing that puzzled him was this: Economic theory postulated that the market provided the most efficient way of coordinating economic activity, and yet no large company seemed to use the price mechanism as a way of coordinating its internal activities. Instead, big corporations operated as command-and-control mini-economies of the kind despised by economists. Why was this?

“I found the answer,” Coase said in his 1991 Nobel lecture, “by the summer of 1932. It was to realize that there were costs of using the pricing mechanism... There are negotiations to be undertaken, contracts have to be drawn up, inspections have to be made, arrangements have to be made to settle disputes and so on. These costs have come to be known as transaction costs. Their existence implies that methods of coordination alternative to the market, which are themselves costly and in various ways imperfect, may nonetheless be preferable to relying on the pricing mechanism, the only method of coordination normally analyzed by economists.”

It sounds simple, but it was a groundbreaking insight because it explained why, for example, companies often became vertically integrated as they grew. Transaction costs are why a manufacturer of car tires would come to own and operate rubber plantations in some fetid tropical country; not because its executives want to farm rubber, but because the transaction costs of not owning the supplier are higher than the costs of operating it themselves.

Transaction costs explain more than just how firms operate, they also help to determine what is produced.

“If the costs of making an exchange are greater than the gains which that exchange would bring,” Coase wrote, “that exchange would not take place and the greater production that would flow from specialization would not be realized. In this way, transaction costs affect not only contractual arrangements, but also what goods and services are produced. Not to include transaction costs in the theory leaves many aspects of the working of the economic system unexplained, including the emergence of the firm, but much else besides.”